1

November 8, 2018

Comments of all sorts are welcome

Un-Faithful Representations of Financial Statements:

Issues in Accounting for Financial Instruments

A. Rashad Abdel-khalik

University of Illinois at Urbana-Champaign

rashad@illinois.edu

Acknowledgments:

I would like to express my appreciation to Theodore Sougiannis and Dongyi (Donny) Wang for commenting on

an early draft and providing very helpful comments. I also benefitted by the questions and comments of the

workshop participants at the University of Illinois at Urbana-Champaign.

2

Un-Faithful Representations of Financial Statements:

Issues in Accounting for Financial Instruments

Abstract

Both of International Financial Reporting Standards (IFRSs) and accounting standards

for the US GAAP categorize hedging relationships as falling into several buckets. The

two buckets of relevance in this paper are (a) hedging the volatility of fair values, and

(b) hedging the volatility of future cash flow. In this paper, I argue in this paper that at

least four accounting treatments of derivatives and hedging lead to serious distortion of

actual transactions and violate adherence to the principle of “faithful representation.”

The four treatments relate to (1) creating a fictional Hypothetical Derivatives Method,

(2) establishing valuation adjustments reflecting credit risk prices in order to report

estimates of the fair values of OTC derivative assets (CVA) and liabilities (DVA), (3)

requiring subjective metaphysical separation of embedded derivatives, and (4) failing to

report hedging as a substitution of risk. To remedy these resulting distortion and

departures from the goals of financial reporting, both standards-setting boards must

undertake significant revisions of accounting for financial instruments and hedging.

1. INTRODUCTION

Accounting standards governing financial instruments and hedging became effective in 2000

(IAS 39 for international accounting standards, and FAS No. 133 for US GAAP). Both types of

standards categorize hedging relationships as falling into several categories.1 The issues of concern in

this paper relate to accounting for fair value hedge and cash flow hedge:

1 These categories are (1) Freestanding vs. Embedded Derivatives; (2) Hedging—General; (3) ;Fair Value Hedges;

(4) Cash Flow Hedges; (5) Net Foreign Investment Hedges; (6) Contracts in Entity's Own Equity; (7) Weather Derivatives

3

A. Fair Value Hedge is for transactions hedging the volatility of fair values of (1) a recognized

asset; (2) a recognized liability; or (3) an unrecognized firm commitment.

B. Cash Flow Hedge is for transactions hedging the volatility of future cash flow of (i) a

recognized asset; (ii) a recognized liability; or (iii) a forecasted transaction.

More specifically, I address some concerns regarding the accounting treatments of (a) hedging

forecasted transactions, (b) setting up valuation allowances, (c) separating embedded derivatives, and

(d) failure to disclosure of hedging as substitution of risk. In addressing these concerns, the two

overriding principles of utmost relevance in this paper are:

A. Faithful Representation: A fundamental quality in The Conceptual Framework of Financial Reporting

is faithful representation. In the Statement of Financial Accounting Concepts No. 8, the FASB states:2

Financial reports represent economic phenomena in words and numbers. To be useful,

financial information not only must represent relevant phenomena, but it also must

faithfully represent the phenomena that it purports to represent. To be a perfectly

faithful representation, a depiction would have three characteristics. It would be

complete, neutral, and free from error. [Emphasis Added, p. 17].

B. Marking to Market: The majority of financial derivatives are bilateral contracts deriving their values and

risks from changes in prices or other indexes that give rise to rights (assets) and obligations (liabilities)

of the two parties to the contract. Absent any other modification, both derivatives’ assets and liabilities

must be valued at fair value and the changes in fair values should be posted to the income statement.

Certain uses of financial derivatives, such as hedging, may modify the cash flow related to derivative

instruments and thus alter the application of this general principle.

2 Financial Accounting Standards Board (jointly with the International Accounting Standards Board. “Conceptual

Framework for Financial Reporting Statement of Financial Accounting Concepts No. 8.” September 2010.

https://www.fasb.org/resources/ccurl/515/412/Concepts%20Statement%20No%208.pdf

https://www.fasb.org/resources/ccurl/515/412/Concepts%20Statement%20No%208.pdf

4

The objective of this paper is to show that the accounting treatments for these items result in (a)

significant deviations from faithfully representing actual transactions and events; (b) distorting

financial statements; (c) hindering transparency, and (d) impairing the comparability of financial

statements over time and in relationship to other firms. In essence, the related standards grant the

managements of the reporting entities the tools to alter the measurement and valuation of OTC

financial derivative instruments as they wish.3

3 Over-the-Counter derivatives are the source of major concerns for valuation and reporting. They are seven time the size

of Organized-Exchange derivatives, change hands in private and have illiquid market. According to the Bank for

International Settlements, the notional amounts of OTC derivatives stands at $549 trillion in the first quarter of 2018, which

is down from a high of $712 trillion in 2011. The growth in these derivatives has overwhelmed all developments of

transacting and accounting. About 45% of that amount is held by the largest 25 banks in the USA. The chart below is

global OTC derivatives and is reproduced from a publication by the Bank for International Settlements.

OTC derivatives notional amount outstanding by risk category

https://www.bis.org/statistics/about_derivatives_stats.htm

https://www.bis.org/statistics/about_derivatives_stats.htmhttp://lbnds115:8089/statx/srs/tseries/OTC_DERIV/H:A:A:A:5J:A:5J:A:TO1:TO1:A:A:3:C?t=D5.1&p=20172&x=DER_RISK.3.CL_MARKET_RISK.T:B:D:A&o=w:19981.20172,s:line.nn,t:Derivatives risk category

5

2. ISSUE ONE

Hypothetical Derivatives and Mythical Accounting

A Prologue: Since 1982 any enterprise could use interest rate swaps to hedge cash flow risk including

the risk of forecasted transactions. Accounting rules require the changes in the fair values of the swap

contract flow through the income statement unless the hedge is effective in which case changes in fair

values flow through Other Comprehensive Income (OCI) for a temporary “parking.” A simple measure

of effectiveness is relating the cumulative changes in the values of the derivative to the cumulative

changes in the values of the hedged position. Because forecasted transactions are uncertain and their

fair values are not measureable, accounting standards allow inventing a fake derivative to stand as a

place holder for the hedged item. In turn, the resulting effects on the income statement and the balance

sheet depart from reality.

Over the years, the management of reporting entities have lobbied hard to have accounting

standards be set in ways to reduce the volatility of earnings. The pressure on the Financial

Accounting Standards Board, for example, intensified after experiencing the earnings volatility of

accounting for translation of foreign currency (FAS No. 8, 1975) which led to issuing a substitute

statement of standard (FAS No. 52, 1983). An outcome of the new standard was to slice a segment

of the income statement for temporary shelving of the balances of certain accounts in the equity

section of the balance sheet. This section is what we know now as Other Comprehensive Income

(OCI). The main objective of OCI is to park the gains or losses of foreign currency translation and

other items that, if included in the income statement, would have increased the volatility of earnings.

OCI became useful in designing accounting for financial derivatives and hedging (1998). To reduce

adding volatility in the measurement of earnings, accounting standards permitted “parking” changes in

the values of derivatives in OCI under certain conditions. These conditions include: (a) the derivative

is designated as a hedge of cash flow risk; (b) the entity prepares a detailed documentation, (b) the

hedged risk is well identified and connected to the firm-wide Enterprise Risk Management system, and

(e) the hedging relationship is effective (successful). However, hedging forecasted transactions does

6

not a priori satisfy these conditions and require adding other modification.

2.1 Forecasted Transactions

The U. S. GAAP Master Glossary defines a forecasted transaction as4

A transaction that is expected to occur for which there is no firm commitment.

Because no transaction or event has yet occurred and the transaction or event when

it occurs will be at the prevailing market price, a forecasted transaction does not give

an entity any present rights to future benefits or a present obligation for future

sacrifices.

:

A transaction that is expected to occur for which there is no firm commitment.

Because no transaction or event has yet occurred and the transaction or event when

it occurs will be at the prevailing market price, a forecasted transaction does not give

an entity any present rights to future benefits or a present obligation for future

sacrifices.

In other words, a forecasted transaction has no real existence, past, present or future; there

was no transfer or commitment for future transfers of resources either way. Thus, a forecasted

transaction remains a highly undefined prospective event whose occurrence might be probable (US

GAAP) or highly probable (IFRS). In this regard, the US GAAP and IFRSs share general similarities

although not fully aligned.

2.2 Volatility of the Hedge Derivative => Volatility of Reported Earnings

Exhibit 1A presents an illustration in which a reporting entity (Company ABC) is forecasting

probable cash payments that are expected to vary with a particular interest rate benchmark. However,

the amounts and timing of expected cash outflow are indeterminable. Accordingly, the management

4 FASB Codification of Accounting standards, Master Glossary.

https://asc.fasb.org/glossary&letter=F

https://asc.fasb.org/glossary&letter=F

7

would have no basis for estimating a fair value for the forecasted transaction. Yet, prudent risk

management led Company ABC to purchase an interest rate swap contract to pay (to the dealer bank)

an amount of interest calculated at a fixed rate and receive interest calculated at a variable rate (e.g.,

LIBOR). As a plain vanilla swap, this contract would have zero fair value at inception and, if no

other arrangements are made, the changes in fair value would flow through the income statement.

Therein lies the management problem of adding to earnings volatility beyond what the management

is willing to tolerate.

Insert Exhibit 1A about here

Exhibit 1A

Hedging a Forecasted Transaction:

Fair Value Changes Flow through the Income Statement

? ?? ?

Company

ABC

Forecasted

Transaction

Swap Dealer

Fix

ed R

ate

Flo

ating

Rate

8

2.3 The Solution: Creating a Fictional Derivative

To shelter reported earnings from the volatility of the derivative acquired to hedge a

forecasted transaction, the management must show that the hedge is effective. However, hedge

effectiveness cannot be established because the changes in the fair values of the acquired derivative

are not matched by corresponding changes in the fair value of the unknown forecasted transaction.

Instead, the standards gave the management the option to establish a “Voodoo Statue” to play the role

of the hedged item and provide an imagined “perfect hedge.” Under these conditions, the

management of Company ABC would have all the excuses it needs to defer the accumulated gains or

losses of the hedge (real financial derivative) in OCI. Both the FASB and the IASB adopted the

“Voodoo Statue” concept, but gave it the elegant name of “The Hypothetical Derivatives Method.”

Exhibit 1B augments Exhibit 1A by adding the magical hypothetical derivative that came down from

a blue sky.

Insert Exhibit 1B about here

9

Exhibit 1B

Hedging a Forecasted Transaction:

A. Fair Value Changes of the Derivative are Posted to OCI

? ?? ?

With perfectly effective hedge, even though it is a fake one, changes in the fair value

of interest rate swap will bypass the income statement and be posted in an equity

account (Other Comprehensive Income) instead.

The Entity Forecasted

Transaction

Swap Dealer

Fix

ed R

ate

Flo

ating

Rate

Hypothetical

Derivative:

[Blue Sky] Perfect Effectiveness

Test

10

The guide for creating the “Hypothetical Derivatives Method” is codified in ASC

815-35-25.5

FASB, 815-35-25

The hypothetical-derivative method measures hedge ineffectiveness based on a comparison of the

following amounts:

a. The change in fair value of the actual interest rate swap designated as the hedging instrument

b. The change in fair value of a hypothetical interest rate swap having terms that identically match

the critical terms of the floating-rate asset or liability, including all of the following:

o 1. The same notional amount

o 2. The same repricing dates

o 3. The same index (that is, the index on which the hypothetical interest rate swap’s variable rate is

based matches the index on which the asset or liability’s variable rate is based)

o 4. Mirror image caps and floors

o 5. A zero fair value at the inception of the hedging relationship.

815-35-26

…

Thus, the hypothetical interest rate swap would be expected to perfectly offset the hedged

cash flows.

….

Internationally, the IASB has adopted the same concept. Section B6.5.5 of IFRS 9, 2014

(page 143) states: 6

To calculate the change in the value of the hedged item for the purpose of

measuring hedge ineffectiveness, an entity may use a derivative that would have

5 This codification is essentially the same as the DERIVATIVES IMPLEMENTATION GROUP. STATEMENT 133

IMPLEMENTATION ISSUE NO. G7. “Cash Flow Hedges: Measuring the Ineffectiveness of a Cash Flow Hedge under

Paragraph 30(b) When the Shortcut Method Is Not Applied.” (July 11, 2000).

http://www.fasb.org/derivatives/issueg7.shtml

6 International Accounting Standards Board. IFRS 9, Financial Instruments, 2014. IFRS Foundation Publications

Department 30 Cannon Street, London EC4M 6XH, United Kingdom

https://asc.fasb.org/glossarysection&trid=2229300&id=SL2311989-113991http://www.fasb.org/derivatives/issueg7.shtml

11

terms that match the critical terms of the hedged item (this is commonly

referred to as a ‘hypothetical derivative’), and, for example for a hedge of a

forecast transaction, would be calibrated using the hedged price (or rate) level.

The hypothetical derivative replicates the hedged item and hence results in the same

outcome as if that change in value was determined by a different approach. Hence, using

a ‘hypothetical derivative’ is not a method in its own right but a mathematical expedient

that can only be used to calculate the value of the hedged item.

The characterization of The Hypothetical Derivatives Method by the FASB and the IASB raises

important questions:

1. If the terms of the forecasted transaction (the hedged item) are delineated well enough such

that they could be replicated and valued, why would the standards suggest creating a

hypothetical derivative as a “place holder” for the hedged item? There is no discussion in

either U. S. GAAP or IFRS to shed light on this issue.

2. The only way that hedging a forecasted transaction be “a perfect hedge” is for the hypothetical

derivate to be an opposite mirror view image of the actual hedge derivative. However, the

Guide ASC 815-35-25 appears to use the term “perfect hedge” to refer to the relationship

between the hypothetical derivative and the forecasted transaction.

The inference that the hypothetical derivative is measured as the inverse of the actual hedge

derivative is not a speculation. Consider, for example, the practice described by the large technology-

consulting firm “SAP” in using “The Hypothetical Derivatives Method,” in one of its programs called

the “Bank Analyzer.”7

7 SAP. Bank Analyzer (FS-BA). Public 2018-6-28, Page 1047

https://help.sap.com/doc/abf8ebe023bc47ecabfd32dd14d62575/9.10/en-US/BankAnalyzer_EN.pdf

https://help.sap.com/doc/abf8ebe023bc47ecabfd32dd14d62575/9.10/en-US/BankAnalyzer_EN.pdf

12

The system uses the existing effectiveness methods but generates fictitious hedging

relationships for them. These fictitious hedging relationships consist of a real hedging

instrument and the corresponding hypothetical derivative. In the fictitious hedging

relationship, the hypothetical derivative represents the hedged item, and the real derivative

the hedging instrument. To be able to use the existing effectiveness test methods, the system

compares the value changes in the hypothetical derivative with the real derivative. As these

changes in value are always consistent, the system reverses the +/- sign before the final

effectiveness indicator is derived. If this was not the case, the determined key figures would

not be consistent with the results in the micro fair value hedging relationships. The

Hypothetical Derivatives Method allows the management to defer the recognition of gains

or losses of the actual financial derivative until the forecasted transaction is no longer a

forecast.

Additionally, in one of his reports, Ira Kawaller acknowledged “The perfect hedge, then is not

one that generally can be traded. It is commonly referred to as the hypothetical derivative and its

settlement amounts are thus…… hypothetical.” Yet, even with this qualification, Kawaller went on

to show using regression analysis to “to transform the features of the actual derivative to get the

associated parameters of the hypothetical derivative.”8

In a more recent report, Kawaller discussed the improvements suggested by Accounting

Standards Update in which he noted the following: 9

FASB has also clarified that whenever a company can assert that the hedging derivative and the

hypothetical derivative are identical, no quantitative test is required; reporting entities must simply

document that the qualifying conditions are satisfied. Again, this attestation is not a one-time event;

reporting entities must revisit the issue quarterly to assure that the stated documentation is still valid.

8 Ira Kawaller. “Hypothetically Speaking: Accounting for Commodity Hedges.” AFP Exchange. (March 2015), pp. 58-61.

https://docs.wixstatic.com/ugd/de837a_c4a7ed959bb749a0811efd061af68cb3.pdf 9 Ira G. Kawaller. “Update on Hedge Accounting Rules. FASB Addresses Effectiveness Concerns.” CPA Journal, March

2018.

https://www.cpajournal.com/2018/04/11/update-on-hedge-accounting-rules/

https://docs.wixstatic.com/ugd/de837a_c4a7ed959bb749a0811efd061af68cb3.pdfhttps://www.cpajournal.com/2018/04/11/update-on-hedge-accounting-rules/

13

2.5 Concluding Issue One

The Conceptual Frameworks of IFRS and US GAAP offer “representational faithfulness”

as a fundamental principle for evaluating the quality of financial statements.10

QC12. Financial reports represent economic phenomena in words and numbers. To be

useful, financial information not only must represent relevant phenomena, but it also

must faithfully represent the phenomena that it purports to represent. To be a perfectly

faithful representation, a depiction would have three characteristics. It would be

complete, neutral, and free from error. Of course, perfection is seldom, if ever,

achievable. The Board’s objective is to maximize those qualities to the extent possible.

However, creating fictitious accounting treatments that change the geography of reported

items between the income statement and the balance sheet could hardly be considered a

faithful representation of the underlying transactions or economic conditions.11

Additionally, for the same exact forecasted transaction, two firms could have very

different treatments affecting the income statement and the balance sheet differently only

by choosing to establish “The Hypothetical Derivatives Method.” In his article

“Hypothetically Speaking,” Ira Kawaller recognized the resulting diversity and

impairment of comparability as a result.12

10 Financial Accounting Standards Board (in collaboration with the International Accounting Standards Board). September.

Statement of Financial Accounting Concepts No. 8. Conceptual Framework for Financial Reporting. September 2010,

page 17

11 Clearly, there are no satisfactory responses to these queries because any negativity associated with creating “The Hypothetical Derivatives Method” had fallen by the wayside. I have raised this concern numerous times with the last time

being in 2013 when I found it objectionable to build a “make believe” transaction that influences reported earnings and

items reported on the balance sheet. See A. Rashad Abdel-khalik. Accounting for Risk, Hedging and Complex Contracts.

Routledge, 2013.

After coming across the information related to The Hypothetical Derivatives Method, one of my former colleagues in

economics made his reaction clear in a private letter to me stating. “You report accounting numbers based on figments of

imagination but criticize economists for making assumption to facilitate the tractability of their models.”

12 Kawaller, 2015. Ibid.

14

Accounting standards state explicitly that derivatives could not be used as “hedged

items.” Yet, an implication of inventing the Hypothetical Derivatives Method is that

financial derivatives may not be designated as hedged item except when they are fake!

3. ISSUE TWO:

CVA & DVA Add more Distortion of the Plastic Valuation of Derivatives

Assets and Liabilities

A Prologue: Unlike other contracts, financial derivative instruments do not specify the amounts and

timing of cash inflows or outflows. Instead, the inflows and outflows are expectations based on expected

market-wide movements. Accordingly, the fair values of for derivatives not traded on organized

exchanges are estimated by discounting the net expected cash flow. For Over-the-Counter derivatives,

these values are completely a function of the forward yield curve and of the management strategies and

goals. Therefore, these values are soft and malleable numbers. Adding to this plasticity is the use of

valuation allowances for derivative assets (credit risk of counterparties) and for derivative liabilities

(own credit risk). There are no guides for setting up these valuation allowances and all approaches used

are homemade not verifiable against any objectively measured yardstick. Finally, these valuation

allowances can be used as hedged items for which other derivatives would be acquired as hedge items.

The accumulated cascade of subjectivity and management’s exercising significant choices leads to

reporting earnings and valuation numbers not representing any reality.

2.1 Plasticity of Valuation of OTC Derivative Instruments

Accounting standards define an asset as the right to receive resources, and a liability as the

obligation to transfer resources out of the entity. Collectively, we had accepted these definitions

almost for all assets and liabilities for which there is active and liquid markets. However, valuation

problems arise in valuing specialized assets and transactions for which there are no active markets.

15

Of special interest is the valuation of Over-the-Counter (OTC) derivatives. Unlike exchange-traded

derivatives, OTC derivative instruments trade privately between counterparties in a highly illiquid

market. In this setting, the valuation of financial instruments are not based on prices generated by

large numbers of market participants. Nor are they based on contractually determined cash flow.

The amounts and timing of future cash inflows and outflows derive from market-wide indexes and

benchmarks whose movements are not influenced by either one of the two contracting parties. For

example, the projected cash flow associated with an interest rate swap contract at any point in time is

conditional on the yield curve, the zero-coupon rates and forward rates—all are indexes determined

by macro, not micro, economic factors. This feature renders financial derivative instruments totally

unlike other contractual commitments in which contracts specify the amounts of resource inflows and

outflows.13

Calculating expected values of assets and liabilities of bilateral derivative contracts draws on

the industry guidance provided by The Master Agreement of the International Swap and Derivatives

Association (ISDA) written in 1985 and revised in 2002.14 Faced with a completely uncertain future,

the Master Agreement provides alternative ways to calculate derivative assets and liabilities. However,

all of the approaches provided hinge on one critical assumption: the future will be an extension of the

present. Accordingly, it works out that the winner in the current period could be presumed to continue

winning and accumulating rights (assets) and the loser in the current period is presumed to continue

13 In general, entities enter into financial derivatives contracts to achieve one or more of the following goals:

To hedge a known, specific risk.

To manage expected risk.

To speculate.

To gamble—i.e., adding risk in the hope of profiting.

14 A little known secret is that ten large banks established ISDA in 1985 and wrote the Master Agreement to serve their own

interests. These banks are Bankers Trust, Citibank, First Boston, Goldman Sachs, Kleinwort Benson, Merrill Lynch,

Morgan Stanley, Morgan Guaranty Trust, Salomon Brothers, and Shearson Lehman Brothers. Currently, the managing

board of ISDA consists of 26 financial institutions, nineteen of which are big banks.

16

losing and accumulating liabilities for the remainder of the contractual maturity.15 Based on these

assumptions, the counterparties forecast various scenarios to estimate different series of “what could

be” cash inflow and cash outflow, then net the expected cash inflows and outflows and discount the

result to present value. The estimated present value is an asset for one party and a liability for the

counterparty because financial derivatives are zero-sum games.16

This approach to generating values of derivatives “assets” and “liabilities” is highly

problematic for several reasons:

a. For future periods, all of the intended services (hedging, managing risk, speculation or

gambling) are contingent performance, i.e., continuation of the contract.

b. No transfer of resources between counterparties related to future periods had taken place

beforehand.

c. The transfer of resources and performance of services in future periods are contingent on the

realization of the expected macroeconomic factors, which are highly uncertain and are not

controllable in the least by either counterparty.

Accordingly, OTC derivative assets and liabilities are simply creatures of assumptions and

hypothetical expectations. It follows that the numbers that accountants report for OTC derivatives

assets and liabilities are essentially assumed, soft, phantom numbers that do not, and could not have

the same hardness and qualitative characteristics of other assets or liabilities on the balance sheet.

15 The amounts are usually determined as the present value of amounts calculated on the basis of the current year’s

difference between the swap forward rate and the fixed rate of the contract times the numbers of years to maturity 16 This is an oversimplification since the readers would need to learn about swap rate curve and other technical factors.

17

Given their unique characteristics, different entities could exercise creativity in estimating the

values of OTC derivatives assets and liabilities by constructing the unknown future conditions in ways

to fit their managements’ goals. No other asset or liability on the balance sheet is a creature of

assumptions in the same way or extent as OTC financial instruments. It is therefore not defensible to

add the “plastic” estimates of assets and liabilities of OTC derivatives to other assets and liabilities that

have harder measures.

2.2 Establishing Valuation Allowances for Derivatives Assets and Liabilities

In the measurement and reporting of fair values, accounting standards require incorporating

“the assumptions of market participants” in estimating the exchange values.17 In a liquid market with a

large number of participants, there is no need to assess the participants’ assumptions; the market

already incorporates them in the observable transaction prices. This rather odd requirement in

accounting standards is of concern primarily to other market conditions in which there are few market

participants with placing the focus on Over-the-Counter (OTC) markets.18 OTC derivatives are

bilateral contracts traded privately in the dark behind closed doors and are, therefore, highly illiquid

17 For the US GAAP

Adoption Effective Old Number Old

Name

New ASC Number

Jun-98 Jun-99 FAS 133 Accounting for Derivative Instruments and Hedging…. ASC 815

Sep-06 Nov-07 FAS 157 Fair Value Measurements ASC 820

Feb-07 Nov-07 FAS 159 The Fair Value Option ASC 825-10-05

Dec-11 Jan-13 ASU No. 2011-11 Disclosures about Offsetting Assets and Liabilities ASC No. 210-20

Jan-16 Dec-17 ASU No. 2016-01 Measurement of Financial Assets and Liabilities ASC 825-10-45-5

• IFRS 13 for International Financial Reporting Standards 18 OTC derivatives have become the monster hidden off sight; the notional amounts of OTC derivatives exceeds $595

trillion ($595,000,000,000,000) worldwide, or seven times the size of global Gross Domestic Product. Of that amount,

$481 trillion are interest rate contracts. See Bank for International Settlements. Global OTC Derivatives Market.

https://www.bis.org/statistics/d5_1.pdf

https://www.bis.org/statistics/d5_1.pdf

18

and their values are not observable. Additionally, the models used in estimating the values of these

derivatives employ the risk free rate to discount expected flows. Thus, the credit risk of counterparties

are not priced. In contrast, hedged items, which are non-derivatives, incorporate adjustment for credit

risk. Thus, there is typically a mismatch between the valuation of derivatives used for hedging and the

valuation of the related hedged items. To correct for this “mismatch,” accounting standards introduced

the concept of “credit standing” and require establishing valuation adjustments for OTC derivative

assets (credit valuation adjustment or CVA) and debt valuation adjustments (DVA) for derivative

liabilities. As measures of pricing credit risk, CVA and DVA are not derived from the same family.

As noted in Kamakura Solutions, CVA is “the difference between the risk-free portfolio value and the

true portfolio value that takes into account the possibility of a counterparty’s default. In other words,

CVA is the market value of counterparty credit risk.”19 CVA is, therefore, a reserve allowance for the

probable default of counterparties that owe the reporting entity money (assets). In contrast, DVA is an

allowance for own credit risk. While CVA is conveying a message that “others may not pay what they

owe the reporting entity,” DVA conveys an unusual signal: “the reporting entity may not pay other

derivatives counterparties to whom it owes money.” This is, of course, quite odd for several reasons.

Estimating numbers for DVA is a recognition of decreasing debt without transferring resources

outside the entity, which would be an increase in equity. When the practice of estimating DVA started,

changes in values were posted to the income statement. “This valuation technique was used by

financial firms in 2008 as a way to minimize accounting losses: as the market value of issued

debt declined, companies would recognize the decline as income.”20

19 Kamakura Solutions. Credit Risk, CVA and DVA.” Kamakura Corporation at

http://www.kamakuraco.com/Solutions/CreditRiskCVAandDVA.aspx

20 Kamakura Solutions, Ibid.

http://www.kamakuraco.com/Solutions/CreditRiskCVAandDVA.aspx

19

Estimating DVA simply means that an enterprise was able to manufacture its own

profits at will. In recent years, in ASU 2016-01, the FASB joined the IASB in requiring

that specific segment of DVA “attributable to instrument-specific credit risk of liabilities for

which the fair value option is elected.” (See paragraph 825-10- 45-5) should be posted to OCI

not to earnings.21

For all other liabilities that are valued at fair value, DVA and the changes thereof continue to

flow through the income statement. As a result, a decrease in the fair value of liabilities continue to

increase owners’ equity through either earnings or OCI. That decrease, however, is self-selected and

self-estimated. There is no specific guidance on the methods or limits of calculating either CVA or

DVA, which creates challenges in estimation.22 However, in general, the inputs to the calculation

include (a) expected exposure to default loss, (b) expected loss severity (1 – recovery rate), (c) the

probability of default and (d) the present value discount factor.23 T h e m e t h o d s of combining these

inputs to form measures of CVA or DVA are left completely to management choice. However,

estimating DVA has a special restriction: “An interesting aspect of the rule is that once reporting

companies adopt this rule for certain securities, switching to a different valuation technique is

prohibited.”24

21 ASU 2016-01, “Financial Instruments—Overall (Subtopic 825-10). Recognition and Measurement of Financial

Liabilities.” Financial Accounting Series. Financial Accounting Standards Board. January 2016.

22 Applying IFRS IFRS 13 Fair Value Measurement Credit valuation adjustments for derivative contracts April 2014

https://www.ey.com/Publication/vwLUAssets/EY-credit-valuation-adjustments-for-derivative-contracts/$FILE/EY-

Applying-FV-April-2014.pdf

23 Donald J. Smith. Valuation in a World of CVA, DVA and FVA: A Tutorial on Debt Securities and Interest Rate

Derivatives. World Scientific Publishing Co. 2018.

24 Kamakura Solutions, Ibid.

https://www.ey.com/Publication/vwLUAssets/EY-credit-valuation-adjustments-for-derivative-contracts/$FILE/EY-Applying-FV-April-2014.pdfhttps://www.ey.com/Publication/vwLUAssets/EY-credit-valuation-adjustments-for-derivative-contracts/$FILE/EY-Applying-FV-April-2014.pdf

20

Because of the absence of any rules, models or guidance for the measurement of CVA or

DVA, some financial economists suggest that CVA for a creditor concerning certain derivatives

(assets) should be the negative of the DVA of the debtors of the same derivatives. Exhibit 2 presents

the impact of symmetrical measures of CVA and DVA to which Smith refers to as “zero net supply.”

It is the notion that “the fair value of a bond (i.e., a financial instrument) is the same amount (in

absolute value) whether viewed by investor (asset holder) or the issuer (debtor).”25

Insert Exhibit 2 about here

Thus, the finance literature appears to have converted measures of CVA and DVA as “market-

wide” measures in which DVA is not a measure of own credit risk based on the debtors’ own

probabilities of default. Rather, DVA would be the estimate of the counterparty creditors as their CVA

regarding their derivatives assets for which the reporting firm is the debtor. Nevertheless, under all

circumstances the measurement of CVA and DVA is driven by management objectives and

assumptions for which there are no means of validating or verifying.

Exhibit 2

The Zero-Net-Supply Concept

(ValueASSET + ValueLIABILITY) = VND – CVA + DVA = 0,

where VND is the value of a fixed-rate bond discounted at the

benchmark interest rate.

CVA is the credit valuation adjustment for a derivative held as an asset

DVA is the valuation adjustment for own credit risk for a derivative debt

Source: Donald J. Smith. Valuation in a World of CVA, DVA and FVA:

A Tutorial on Debt Securities and Interest Rate Derivatives.

World Scientific Publishing Co. 2018.

25 Smith. Ibid. P. 17.

21

3.2 Muddying the Water Even More—Hedging CVAs and DVAs

There are at least two more complicating factors in estimating the fair values of OTC derivative

assets and liabilities.

1. Firms may enter into other derivative contracts to hedge the estimated Credit Valuation

Allowance (CVA) and Debt Valuation Allowances (DVA). The gain or loss on these hedging

relationships would be treated as the gain or loss of the original derivative for which the

valuation allowances were set up. However, hedging CVA is as absurd as hedging the

Accounts Receivable Allowance. Moreover, hedging DVA is as absurd as hedging the entity

own guarantee of its own debt.

2. Establishing DVA is like the reporting entity “insuring” its own debt. Moreover, DVA leads to

a perverse effects. As the credit worthiness of the reporting entity deteriorates, estimates of

DVA increases and the earnings of the reporting entity increase. Establishing a DVA (a

valuation allowance) to reflect the alleged deterioration of own credit risk is an unconstrained

choice act by the management.26 Nevertheless, when it comes to OTC derivatives, accounting

standards have given the management the implicit license to claim that it may not be able to

pay its derivative debt obligations irrespective of whether or not the entity is facing financial

distress. It is a choice that increases income and distorts the valuation of derivatives on the

balance sheet. This aberrant outcome is a unilateral manufacturing of own profits and

rearranging the geography of the income statement and balance sheet. to equity (profit) at will.

26 During my presentation of this paper at a workshop, Tim Brown, an assistant professor at the University of Illinois, asked

rhetorically: What if Wal-Mart, for example, buys produce from farmers and tell them ‘the company may not be able to pay

you’?

22

Insert Exhibit 3 about here

As an illustration, let us consider JPMorgan Chase (Exhibit 3). The bank is highly liquid and have no

threat of defaulting. Yet, it is benefiting by the accounting standards gift of estimating DVA at levels

that impact reported income significantly. For example, it is actually surprising that, in fiscal year

2011, about 23% of net income came from DVA—earnings manufactured by the management (p.

81).27

Net revenue included a $1.4 billion gain from DVA on certain structured and derivative liabilities

resulting from the widening of the Firm's credit spreads. Excluding the impact of DVA, net

revenue was $24.8 billion and net income was $5.9 billion.

In 2012, adjustments to DVA reduced earnings by $930 million (Exhibit 4). The implication of

reversing the amounts of DVA is that JPMorgan Chase had an elevated risk of default in 2011 more

than it did in 2012. In reality, however, fiscal year 2012 was the year of disclosing more than $6.0

billion loss in the case of “The London Whale.”28 Thus, JPMorgan Chase has a unique history fiscal

year of 2012. In that year the “marketplace” by getting deep into credit default swaps but gained in

“accounting” by managing the estimates of DVA. It is not clear how anyone could claim that the

resulting reports after adjusting for CVA and DVA adhere to the “faithful representation principle”

while permitting the management to manufacture profits.

27 JPMorgan Chase & Co. Form 10-K of 2013, Page 81.

http://files.shareholder.com/downloads/ONE/6330626209x0xS19617-12-163/19617/filing.pdf

The $5.9 billion income is, of course, after tax. But DVA is not recognized as a taxable item and all the $1.4 billion went

straight to earning.

28 Homeland Security & Governmental Affairs. JPMorgan Chase Whale Trade: A Case History of Derivatives Risks and

Abuse. March 15, 2013.

https://www.hsgac.senate.gov/subcommittees/investigations/hearings/chase-whale-trades-a-case-history-of-derivatives-

risks-and-abuses

http://files.shareholder.com/downloads/ONE/6330626209x0xS19617-12-163/19617/filing.pdfhttps://www.hsgac.senate.gov/subcommittees/investigations/hearings/chase-whale-trades-a-case-history-of-derivatives-risks-and-abuseshttps://www.hsgac.senate.gov/subcommittees/investigations/hearings/chase-whale-trades-a-case-history-of-derivatives-risks-and-abuses

23

Exhibit 3

CVA & DVA of JPMorgan Chase in 2011 and 2012

Notes to consolidated financial statements

Credit adjustments

When determining the fair value of an instrument, it may be necessary to record adjustments to the Firm’s

estimates of fair value in order to reflect the counterparty credit quality and Firm’s own creditworthiness:

• Credit valuation adjustments (“CVA”) are taken to reflect the credit quality of a counterparty in the

valuation of derivatives. CVA adjustments are necessary when the market price (or parameter) is

not indicative of the credit quality of the counterparty. As few classes of derivative contracts are

listed on an exchange, derivative positions are predominantly valued using models that use as their

basis observable market parameters. An adjustment is necessary to reflect the credit quality of each

derivative counterparty to arrive at fair value. The adjustment also takes into account contractual

factors designed to reduce the Firm’s credit exposure to each counterparty, such as collateral and

legal rights of offset.

• Debit valuation adjustments (“DVA”) are taken to reflect the credit quality of the Firm in the

valuation of liabilities measured at fair value. The methodology to determine the adjustment is

generally consistent with CVA and incorporates JPMorgan Chase’s credit spread as observed

through the credit default swap (“CDS”) market.

The following table provides the credit adjustments, excluding the effect of any hedging activity,

reflected within the Consolidated Balance Sheets as of the dates indicated.

Source: Form 10-K, December 31, 2012. Page 211

https://jpmorganchaseco.gcs-web.com/node/107676/html

https://jpmorganchaseco.gcs-web.com/node/107676/html

24

This is what Lisa Pollack of the Financial Times called “utterly mad,” given that the U. S. has

enacted a safe harbor rule protecting swap counterparties.29

The risk that the bank that is reporting results will default and therefore not pay out. FT

Alphaville would expect these to be labelled as “DVA”. That is, if the reporting bank owed other

banks a lot of money on various derivative positions, but the bank’s creditworthiness deteriorated,

then the claims could be marked down by the logic of DVA because the bank may default before

paying out to its counterparties.

That, conceptually, strikes us as utterly mad. US bankruptcy has a safe harbour specifically for

swap counterparties to be able to close out at fair value. In other words, filing for bankruptcy is

unlikely to alleviate a bank of the requirement to pay out. Even the extreme, where this bit of

accounting should surely make sense, is in fact ludicrous.

Bank of America – “DVA trading adjustment” – $1.7bn

2. The risk that the counterparties of the reporting bank will default. There are many ways

to hedge against one’s counterparty exposures. One may use credit default swaps, credit indices,

bonds, equities, and all other manner of derivatives. One can also adjust inventory levels to move

the net short position to counter the net long when the bank is in-the-money to a counterparty.

CVA can therefore be net of hedges or can just consider the mark on the hedges.

Citi – “derivatives CVA net of hedges” – $333m

JP Morgan – “credit valuation adjustments (“CVA”) on derivative assets, net of hedges” –

$(691)m (

25

The report further identified the valuation of derivatives as Level 2, while CVA was Level 3. Here, the

company referred to DVA as CVA. Similarly, Ennis Communications Corporation combined CVA and

DVA under the banner of “CVA.”

In accordance with ASC Topic 820, the Company made Credit Value Adjustments (CVAs) to

adjust the valuation of derivatives to account for our own credit risk with respect to all derivative

liability positions. The CVA was accounted for as a decrease to the derivative position with the

corresponding increase or decrease reflected in accumulated other comprehensive income (loss)

for derivatives designated as cash flow hedges. The CVA also accounted for nonperformance risk

of our counterparty in the fair value measurement of all derivative asset positions, when

appropriate. 31

Finally in these illustrations, Indiana University Medical Center, Inc. reported adjustment of

derivative liabilities, but referred to DVA as CVA.32

Guidance on fair value accounting stipulates that a credit valuation adjustment (CVA) should be applied to the mark-to-market valuation position of interest rate swaps to more closely capture the fair value of such instruments. As of June 30, the fair value of interest rate swaps was a liability of $110,650, which is net of CVA of $15,974. As of December 31, 2014, the fair value of interest rate swaps was a liability of $145,339, which is net of CVA of $9,837. The fair values of the swaps have been included with noncurrent liabilities in the accompanying consolidated balance sheets.

3.4 Concluding Issue Two

a. Companies value financial derivatives traded off organized exchanges using “other”

inputs, which typically disqualify then for valuation at Level 1 of the Fair Value

Hierarchy. Since both Level 2 and Level 3 involve judgment and estimation at different

31 Emmis Communications Corporation. Form 10-K for 2012, page 77.

https://www.sec.gov/Archives/edgar/data/783005/000119312512223521/d335769d10k.htm

32 Consolidated Financial Statements Indiana University Health, Inc. and subsidiaries Years Ended December 31, 2015 and 2014. With Report of Independent Auditors

https://www.in.gov/isdh/files/2015_Indiana_University_Health_AFS.pdf

https://www.sec.gov/Archives/edgar/data/783005/000119312512223521/d335769d10k.htmhttps://www.in.gov/isdh/files/2015_Indiana_University_Health_AFS.pdf

26

degrees, the valuation of derivative assets and liabilities will be guided by other

management goals.

b. While the obtained values of derivatives assets and liabilities are “soft” numbers,

managers estimate valuation allowances: Credit Valuation Allowance (CVA) to adjust

values of assets to include counterparty credit risk, and Debt Valuation Allowance

(DVA) to adjust values of own debt to reflect own credit risk. By construction and

necessity, all estimates of CVA and DVA are made at Level 3 of the fair value

hierarchy.

c. The combination of the two estimates of fair values and the valuation adjustments lack

any objective measures and are completely dependent on the management’s

assumptions and goals.

d. The aggregation of the valuation of OTC derivatives, establishing arbitrary valuation

allowances for assets (CVA) and for liabilities (DVA) and including the results of

hedging CVA and DVA magnifies the plasticity of the numbers reported derivatives for

assets and liabilities. Thus, these numbers are representations of management wishes,

not representation of true transactions.

27

4. ISSUE THREE

The Futility and Distortion of Separating Embedded Derivatives

A Prologue: An embedded derivative is a derivative within a non-derivative contract that cannot be

physically detached or transferred. Unlike hedge accounting, separation of embedded derivatives is a

requirement, not a choice. When metaphysically separated, an embedded derivative would be valued as

a similar freestanding derivative and the value of the host contract, debt or equity, would be the residual

amount of the book valued of the hybrid instrument net of the estimated value of the embedded derivative.

A combination of embedded derivatives must be valued as one. The changes in the values of embedded

derivative flow through the income statement. This is another means handed to management to create

profits at will and, in the process, distort the reported values of the debt or equity host contracts. To this

day, neither the FASB nor the IASB has provided any evidence on the cost/benefit analysis of separating

embedded derivatives.

4.1 Embedded Derivatives

A hybrid instrument consists of at least two components (1) a debt or equity component,

and (b) a feature that modifies the cash flow of the first component. Accounting standards have

taken the steps of providing a process by which these two components be valued and recognized

separately when the value and risk generators of both components are different and when the

hybrid is not valued at fair value through earnings.

After separation, the first component is known as the host contract and the second

component is the financial derivative. If the second component is physically separable as in the

case of detachable warrants, it would be treated as a freestanding derivative. But if it is not

separable as in the case of attached warrants, it is considered embedded.

Other common examples of hybrid securities are callable bonds, puttable bonds and

convertible bonds. A callable bond consists of a debt contract modified by an option giving the

issuer the right to call the bonds for redemption under some specified conditions. A puttable bond

28

consists of a debt contract and an embedded option giving the investor the right to put the bond

back to issuer under some specified conditions. A convertible bond is a debt contract and an

embedded option giving the holder the right to convert the bond into common shares of the same

entity (a call option). It is also possible that the issuer keeps the right to call for the conversion

(put options). In each of these cases, the related options are not physically separable or

transferable independent of the entire hybrid contract and is therefore embedded but may have

similar cash flow effects as the effects of freestanding derivatives.

To account for embedded derivatives, accounting standards aimed at maintaining symmetry

with accounting for the similar but freestanding derivatives. Standards setters adopted this

symmetry as the preferable goal without consideration of the cost/benefit relationships of

implementing that standard. This means that embedded derivatives should be valued at fair

values and changes in fair values flow through the income statement as in the case of securities

held for trading. To implement this accounting, the hybrid instrument must undergo metaphysical

separation (which the US GAAP refers to as ‘bifurcation’) into a host and an embedded derivative

components. Both of IFRS and US GAAP set very much similar criteria for performing that

separation.33 Three of these criteria are of significance.

1. The value and risk generators of the embedded derivative and of the host contract are different.

2. The hybrid instrument is not measured at fair value through the income statement.

3. The embedded feature would be a derivative if it were freestanding.

33 In the 2018 revision, IASB allowed the separation possibility for financial liabilities and other types of contracts such

as a forward contract with options, but not for financial assets. According to this revision, hybrid instruments in

financial assets having embedded derivatives should be valued in its entirety at fair value through profit or loss

statement—FVTPL.

29

When separated, the accounting treatment of the host contract will not change but the

embedded derivative will be valued at fair value through the income statement. Surprisingly

though, the value of the host contract would be measured as a residual; it is the value of the hybrid

net of the estimated fair value of the embedded derivative (s). Stated differently, valuation of the

embedded derivative(s), which is subject to making many assumptions, controls the allocation of

the fair value of the hybrid to the host contract and the embedded derivative.

All of that might sound simple and straightforward but the fascination of the business world

with financial derivatives has emboldened financial engineers to develop much more complex

hybrid instruments that are challenging to bifurcate. The valuation of the embedded derivatives in

these types of hybrid contracts reverts to Level 3 fair value measurement, allowing the management

of the reporting entity to apply parameters and implement strategies that fit its own objectives.

With the attendant difficulties in the valuation of embedded derivatives and the related host

contracts, one would have expected either the FASB or the IASB to offer some convincing

evidence or arguments showing that the benefits of separating and recognizing embedded

derivatives exceeds, or even get close to, the cost of doing so. In fact, the metaphysical separation

of embedded derivatives could misinform investors of the true performance and financial

conditions of the reporting entity as well as the extent of the firm’s indebtedness. To support these

arguments, let us look at three cases—two complex contracts and a case of using embedded

derivatives to seriously distort reported earnings.

4.2 Cases in Accounting for Multiple Embedded Derivatives

On February 24, 2003, Deutsche Telekom Finance issued €2,288,500,000 of 6.5%

Guaranteed Mandatory Convertible Bonds to ordinary (common) shares Due 2006. This is one

type of hybrid contracts in a family of convertibles known as Debt Exchangeable for Common

30

Stocks (DECS), which typically has more than one embedded derivative. This bond offering

was mandatorily convertible at one of three different mandatory conversion ratios (and prices)

all of which are contingent on levels of ordinary share prices. To decide on the relevant

conversion ratio, the offering prospectus defines (a) the “Maturity Share Price” as “the

arithmetic average of the daily Closing Prices of the Shares on the twenty consecutive Trading

Days ending on the third Trading Day immediately preceding the Final Conversion Date” and

(b) the “Initial Share Price” means €11.80.

By reference to these prices, Deutsche Telekom offers three possible conversion ratios:

a. Maximum Conversion Ratio. If the Maturity Share Price is less than or equal to the Initial

Share Price, the conversion ratio shall be equal to 4,237.

b. Minimum Conversion Ratio. If the Maturity Share Price is equal to or greater than the

Conversion Price, the conversion ratio shall be equal to 3,417.

c. Medium Conversion Ratio” If the Maturity Share Price is neither less than or equal to the

Initial Share Price nor equal to or greater than the Conversion Price the conversion ratio shall

be equal to the Principal Amount divided by the Maturity Share Price. Exhibit 5 show the three

stages values and conversion ratios.

31

Exhibit 4

Values and Conversion Ratios of Deutsche Telecom

Mandatory Convertible Bonds

X L Lower strike price. = X U = Upper strike price.

A. Conversion

Value Limits

B. Varying

Conversion

Ratios

32

Few authors have tackled the valuation of DECS (Enrico Arzac, 1997 and Ammann and

Seiz, 2006). Arzac noted that DECS is a compound hybrid having at least two embedded

derivatives. He suggested the following model for estimating the fair value of this hybrid.

Fair Value =

The value of a call option with upper strike price times the lower conversion ratio

– Value of a put option with lower strike price times the upper conversion ratio +

Present value of the risk-free par value + Present value of the risk coupon payments.

(Source: Arzac, 1997; Ammann and Seiz, 2006)

However, for convertible debt of Deutsche Telekom AG, the mandatory conversion scheduled

for June 2006 could be considered a “forward contract.” In this case, the convertible debt of Deutsche

Telekom would have embedded derivatives consisting of a put option, a call option and a forward

contract priced at Maturity price, which is the arithmetic average price over specified twenty days.

For accounting purposes, the related standards call for treating these three derivatives as a single

derivative if the conditions of separating embedded derivatives are met. In this case, the combined

forward, call and put options would be valued at fair value and the book value of the host contract will

be equal to the value of the hybrid less the estimated fair value of the combined derivative.

While this process is complex, it turned out that Deutsche Telecom AG had actually bifurcated

embedded derivatives and reported separate values for the “combined” derivatives and the host

contract, which was recorded as “Contingent Capital.” Nonetheless, once we look at the accounting

treatments under IFRS and US GAAP, questions arise as to the benefits of such bifurcation. In this

case, the accounting treatments under IFRS and US GAAP produced completely different (complex

and confusing) results. In its 6-K filings with the US Securities and Exchange Commission, Deutsche

33

Telekom AG disclosed the following information about this particular issue of DECS (I annotated the

published text below to highlight the differences):31

Mandatory Convertible Bond

In 2003, the Company issued a mandatory convertible bond.

• Under IFRS the components of the mandatory convertible bond were bifurcated into a

debt component and an equity component, resulting in a negative value being ascribed to

the equity component and a higher value (premium) to the debt component. This premium

was amortized as an adjustment (decrease) to interest expense over the term of the bond.

• Under U.S. GAAP, no value was ascribed to the equity component, with the entire

proceeds received recorded as a liability.

• The conversion date was June 1, 2006. Therefore, no U.S. GAAP difference in

shareholders’ equity exists as of December 31, 2006 and as of June 30, 2007, although the

net profit for the six-month period ended June 30, 2006, reflects differences for the period

from the beginning of the year until conversion. In 2005, the dividend paid on the

Company’s common shares resulted in a conditional obligation to pay a special dilution

payment to the holders of the mandatory convertible bonds at conversion. Under U.S.

GAAP the conditional payment represented an embedded derivative and the Company

recorded the estimated fair value of the liability of EUR 45 million at December 31, 2005.

31 US Securities and Exchange Commission. Form 6-K REPORT OF FOREIGN PRIVATE ISSUER PURSUANT TO

RULE 13a-16 OR 15d-16 UNDER THE SECURITIES EXCHANGE ACT OF 1934, August 2007, page 57. http://www.wikinvest.com/stock/Deutsche_Telekom_AG_(DT)/Filing/6-K/2007/F4951044

http://www.wikinvest.com/stock/Deutsche_Telekom_AG_(DT)/Filing/6-K/2007/F4951044http://www.wikinvest.com/stock/Deutsche_Telekom_AG_(DT)/Filing/6-K/2007/F4951044http://www.wikinvest.com/stock/Deutsche_Telekom_AG_(DT)/Filing/6-K/2007/F4951044http://www.wikinvest.com/stock/Deutsche_Telekom_AG_(DT)/Filing/6-K/2007/F4951044

34

Case 2: Another Complex DECS Hybrid:

Telecom Italia Finance—Mandatory Convertible Bonds

Valuation of a call plus a put option in one complex hybrid as in the case of Deutsche Telekom

Finance could be difficult but not as difficult as the valuation of numerous derivatives embedded

in other complex contracts such as the one issued by Telecom Italia Finance on November 8,

2013. The placement prospectus was for the sale of €1,300 million of Guaranteed Subordinated

Mandatory Convertible Bonds due 2016. The prospectus was a lengthy (7,434 words condensed in

15 pages) and a complex prospectus.34 The face value of each bond was €100,000. The bonds

must be converted into ordinary (common) shares with the reference price on the date of issuance

being set at €0.6801.

o This reference price was set as the minimum conversion price, giving a maximum

conversion ratio of 147,037 per bond.

o The maximum conversion price was set at €0.8331, giving a conversion ratio of

120,033 per bond.

o But the relevant conversion price was either the minimum or an average price falling

below the maximum and above the minimum.

Close to maturity date three years from issuance, Telecom Italia Finance will provide the

holders with a Physical Delivery Notice. Shortly thereafter, bondholders will be obligated to

convert the bonds they hold into Ordinary Shares. A quick examination of this contract suggests that

this hybrid instrument includes several embedded derivatives some of which are the following:

34 http://www.tifinance.lu/_NEWS/Telecom_Italia_Finance_Mandatory_Convertible_Notes- Ordinary_Share_Pricing_Termsheet_vF.PDF

http://www.tifinance.lu/_NEWS/Telecom_Italia_Finance_Mandatory_Convertible_Notes-Ordinary_Share_Pricing_Termsheet_vF.PDFhttp://www.tifinance.lu/_NEWS/Telecom_Italia_Finance_Mandatory_Convertible_Notes-Ordinary_Share_Pricing_Termsheet_vF.PDFhttp://www.tifinance.lu/_NEWS/Telecom_Italia_Finance_Mandatory_Convertible_Notes-Ordinary_Share_Pricing_Termsheet_vF.PDFhttp://www.tifinance.lu/_NEWS/Telecom_Italia_Finance_Mandatory_Convertible_Notes-Ordinary_Share_Pricing_Termsheet_vF.PDF

35

• Mandatory Conversion: After Telecom Italia Finance provides bondholders with the Physical

Delivery Notice, all bondholders will be obligated to convert the bonds they hold into ordinary shares

at the ‘relevant conversion price.’

• Early Conversion at the Option of the Issuer:

Telecom Italia Finance, the issuer, may elect to trigger the conversion of the Guaranteed

Subordinated Mandatory Convertible Bonds into Ordinary Shares at any time after the 40th

day after the Settlement Date (which is November 13, 2003). In this time after the 40 case,

the maximum conversion ratio will be applied.

• Early Conversion at the Option of the Bondholder.

o If the bondholder wants to settle in cash prior to the Final Delivery Notice, the issuer will

calculate and pay the relevant cash settlement.

o The bondholder has the option to trigger the conversion of the bonds into Ordinary Shares

at any time after the 40th day after the Settlement Date (November 13, 2003). In this case,

the minimum conversion ratio will be applied.

• Voluntary Conversion at the Option of the Bondholder Following either one of two Special Events

such as if a third entity took control of the Guarantor, which is also Telecom Italia Finance

According to one interpretation, the embedded derivatives noted above might be treated as

one forward contract, one put option and three call options. Other scholars might be able to

identify more embedded derivatives in this convertible debt contract issued by Telecom Italia

Finance on November 8, 2013. As in the previous case of Deutsche Telekom Finance, if the

hybrid instrument was not valued at fair value through the income statement, we will need to

evaluate whether the derivatives embedded in the hybrid instrument of Telecom Italia Finance

should or should not be separated from the host contract (the debt, which was actually “contingent

capital”). But accounting standards also require treating all these embedded derivatives either as a

“unit” for the purpose of bifurcation if the conditions of separation are met or, alternatively, value

the entire hybrid at fair value through earnings. Given the best known and most sophisticated

36

financial engineering tools, it is not possible that any single value obtainable for this collection of

embedded derivatives will be any more reliable than values determined by an arbitrary judgment.

In either case, neither the reported values of convertible debt and recognized income reflect the

true picture of debt or profitability. The next case is a vivid case of misusing embedded

derivatives.

Case 3: Pliable (and Expandable) Valuation of Embedded Derivatives:

The Case of Landsvirkjun

Landsvirkjun is an Icelandic company that employs geothermal resources to produce

electricity. The main buyers of the electricity are U. S. Aluminum companies operating their mining

activities in Iceland. In 2006, the company switched its accounting system from Icelandic GAAP to

IFRS and designated the U. S. Dollar as its functional currency. With that change, the company began

to look into implementing the accounting rules for financial instruments, including embedded

derivatives. The management determined that the price of aluminum affects the contracts to sell

electricity to aluminum companies, which creates an embedded derivative. As a new adopter of IFRS,

the management was required to examine all active contracts to identify and value embedded

derivatives as of the start of each contract. The management acknowledged that the valuation of the

separated embedded derivatives is based on models the company has developed. While the resulting

values are a ‘level three’ type of fair value estimation, Landsvirkjun provided no information that

would permit any external user of financial statements to know the models the company used.

Following the switch to IFRS, the management of Landsvirkjun used the newly found magical

37

accounting standard to manage earnings. In 2009, the company had a loss from operations of $660,

but revaluation of embedded derivatives add $755.7 million in gains to net income.35

Financial income in excess of financial expenses totaled USD 95.1 million in 2009, while

financial expenses in excess of financial income amounted to approximately USD 660.6

million the year before. The difference of USD 755.7 million can largely be attributed to

fair-value changes in embedded derivatives relating to the company’s electric power sales

contracts with aluminium smelters, which move in line with world market prices for

aluminium. (p. 18).

For this relatively small company, using the valuation of embedded derivatives has indeed

distorted the balance sheet and performance information reported to investors and was in fact

misleading.

4.3 Issue Three Conclusion

The main points of discussing embedded derivative in this note may be viewed in terms of queries.

Query 1.

How reliable would be the management valuation of a combination of embedded derivatives?

Query 2.

How reliable, or pliable, are the reported values of host contracts, whether assets or liabilities,

as the “residual” after estimating the value of embedded derivatives?

Query 3.

35 http://www.landsvirkjun.com/media/enska/finances/Annual_report_2009.pdf

http://www.landsvirkjun.com/media/enska/finances/Annual_report_2009.pdfhttp://www.landsvirkjun.com/media/enska/finances/Annual_report_2009.pdf

38

Other than the management, how and in what ways would any information provided to

investors about the separation or bifurcation of a collection of complex embedded derivatives

in one hybrid instrument be useful to any user of financial statements?

Query 4.

The benefits of separating and accounting for embedded derivatives are at best enigmatic.

Does either the IASB or the FASB have any evidence to substantiate that separating embedded

derivatives passes the cost/benefit test?

Query 5.

Since the separation and valuation of embedded derivatives are idiosyncratic to each firm, how

much would the abstract separation of embedded derivatives imped comparability of the

financial reports?

5. ISSUE FOUR

Failure to Disclose Hedging as a Substitution of Risk

A Prologue: A plain vanilla swap is a contract to exchange interest dollars calculated at a fixed rate for

interest for dollars calculated at a variable, adjustable rate. For an asset holder, the fixed rate payer

would be hedging fair value risk. This hedger exchanges the volatility of fair values for the volatility of

cash flow. For a debtor, paying a fixed rate for the swap would be hedging cash flow risk. This hedger

would be hedging the volatility in cash flow for the volatility in fair value. The reverse is true for the

counterparties in both cases. It is therefore obvious that hedging using interest rate swaps is a

substitution of risk. Accounting standards make use of the success (effectiveness) of the hedged risk but

fully ignore the success or failure of the assumed risk. As a result, accounting standards fail to provide

a comprehensive measure of the success of aggregate risk exposure of the hedger.

5.1 The Concept of Risk Substitution

In general, hedge accounting requires documentation of the specific risk being hedged. The

hedged risk could fall into one of the three buckets: cash flow risk, fair value risk, or the risk of

39

changing value of foreign net investments. We want to focus on the first two types. Financial

reporting gives the implicit and false view that hedging either cash flow risk or fair value risk does not

result in risk substitution. This phenomenon is best explained by looking at hedging using interest rate

swaps.

For an entity to hedge the cash flow risk of a variable rate debt instrument, for example, the

entity may enter into an interest rate swap to receive variable rate and pay fixed rate. By converting a

variable rate debt into a fixed rate debt, the entity has in effect taken on fair value risk. Similarly, by

hedging the cash flow risk of a variable rate asset, the entity might enter into a plain vanilla swap

contract to receive fixed and pay variable. Thus, hedging in this case would have changed the

exposure from cash flow risk to a fair value risk.

Exhibit 5 shows the combination of using plain vanilla interest rate swaps to hedge financial

risk exposure of a financial item (asset, liability or firm commitment). The four combinations of

paying or receiving variable rates shows that using interest rate swaps to hedge cash flow risk is also a

mechanism to take on fair value risk. Similarly, using interest rate swaps to hedge fair value risk is a

mechanism to take on cash flow risk. This notion of risk substitution is totally ignored in the literature.

Insert Exhibit 5 about here

40

Exhibit 5

Interest Rate Swaps as Instruments of Risk Substitution

Case A:

• If the hedged item generates income

at a fixed rate,

• The swap would be structured to

receive variable & pay fixed

• Convert a fixed rate to a variable rate

• Hedge fair value risk

• Take on cash flow risk

The Outcome:

Increased exposure to liquidity risk

A Comprehensive Index of Hedge

Effectiveness

The ratio of the fair value risk given up in

relation to the substitute cash flow risk.

Case B

• If the hedged item generates income

at a variable rate,

• The swap would be structured to

receive fixed & pay variable

• Convert a variable rate to a fixed rate

• Hedge cash flow risk

• Take on fair value risk

The Outcome:

Reduced exposure to liquidity risk

A Comprehensive Index of Hedge

Effectiveness

The ratio of the cash flow risk given up in

relation to the substitute fair value risk.

41

5.2 The Problem

The accounting treatment of any hedging relationship is critically dependent on the success or

effectiveness of a hedging relationship. The most descriptive way of measuring success is to see how

much of the cumulative change in the value of the hedged item was compensated for by a reverse

change in the value of the hedge item (the derivative)—i.e., this is the Dollar Offset Raito Method.

Succeeding in meeting the required target and applying hedge accounting signals to the world that the

entity has managed its risk exposure well. However, that inference is false because when an entity

hedges a fixed rate item, it manages exposure to the volatility of fair value (in part or in full) but takes

on full exposure to cash flow risk. Similarly, when an entity hedges a variable rate item, it manages

exposure to the volatility of cash flow (in part or in full) but takes on the full volatility in fair value.

Accordingly, the success of a hedging relationship should not be measured by the extent of hedging an

existing risk without any consideration of the assumed risk. Instead, the relevant yardstick should be

comprehensive by evaluating the success of the entire package—i.e. evaluating the success of the

managed risk in relationship to the burden of the newly assumed risk. For example, a hedging

relationship could hardly be called successful or effective for an entity that achieves 80% of hedging

exposure to fair value risk but takes on 100% exposure to the substituted cash flow risk. Similarly,

success in managing cash flow risk should be measured as the entity’s net exposure—the percentage of

the hedged cash flow risk relative to the burden of the assumed substitution of fair value risk.

Unfortunately, there is no recognition or discussion of this notion of risk substitution and the

impact on the risk profile of entities engaged in hedging. The literature as well as accounting standards

are completely silent in this regard. Clearly, it would not be serving investors and absentee

stakeholders well to convey the belief of success in managing parts of one type of risk while hiding the

full scale of the acquired substitute risk.

42

6. Concluding Remarks

Following the establishment of Over-the-Counter market in the mid-1980s, Accounting

standards’ boards have provided creative methods to account for OTC derivatives which are financial

instruments whose market values are not observable. These creative methods have helped the

management of reporting entities to manage both reported earnings and the financial position of the

firms they manage. In the process, the standards have also succeeded in significantly overloading

users of financial statements with highly complex structures and lingo that have seriously damaged the

usefulness of public financial reporting. In this paper, I address only four of the problems of

accounting for OTC derivatives that distort the financial statements and make them far less

representative of the true financial pictures of the reporting entities. These problems are (a)

Developing accounting processes that impact earnings, assets and liabilities based on a fiction called

“The Hypothetical Derivative.” (b) Reporting highly malleable and plastic-like values of derivatives

assets and liabilities. (c) Distorting the income statement and the balance sheet by requiring a

metaphysical separation of embedded derivatives. (d) Failing to provide an index or a measure of

success in hedging by recognition the reality of risk substitution. Finally, I am not aware of any

evidence provided by either the FASB or the IASB to substantiate the benefits of any of these

accounting treatments or whether any of them could pass the cost/benefit test.

43

References

Abdel-khalik, A. R. (2013). Accounting for Risk, Hedging and Complex Contracts. Routledge, London, New

York.

ASU 2016-01, “Financial Instruments—Overall (Subtopic 825-10). Recognition and Measurement of Financial

Liabilities.” Financial Accounting Series. Financial Accounting Standards Board. January 2016.

Ammann, Manuel and Ralf Seiz. (2006). Pricing and Hedging Mandatory Convertible Bonds. Journal of

Derivatives, Vol. 13: 30–46.

Arzac, E. R. (1997). PERCS, DECS, and Other Mandatory Convertibles. Journal of Applied Corporate Finance,

Vol. 10, No. 1. Spring: 54–63.

Bank for International Settlements. Global OTC Derivatives Market.

https://www.bis.org/statistics/d5_1.pdf

Barth, Mary E., Wayne W. R. Landman, & Mark Lang (2008). International Accounting Standards and

Accounting Quality. Journal of Accounting Research, 46 (39) 467 – 498.

Consolidated Financial Statements Indiana University Health, Inc. and subsidiaries Years Ended December 31,

2015 and 2014. With Report of Independent Auditors

https://www.in.gov/isdh/files/2015_Indiana_University_Health_AFS.pdf

Emmis Communications Corporation. Form 10-K for 2012, page 77.

https://www.sec.gov/Archives/edgar/data/783005/000119312512223521/d335769d10k.htm

Financial Accounting Standards Board. (July 11, 2000). DERIVATIVES IMPLEMENTATION GROUP.

STATEMENT 133 IMPLEMENTATION ISSUE NO. G7. “Cash Flow Hedges: Measuring the

Ineffectiveness of a Cash Flow Hedge under Paragraph 30(b) When the Shortcut Method Is Not Applied.”

http://www.fasb.org/derivatives/issueg7.shtml

Financial Accounting Standards Board, (September 2010). Statement of Financial Accounting Concepts No. 8

Hoffman, Frederick. (2011). “Credit Valuation Adjustment.” MSc Thesis. University of Oxford, Trinity.

http://eprints.maths.ox.ac.uk/1374/

Homeland Security & Governmental Affairs. (March 15, 2013). JPMorgan Chase Whale Trade: A Case

History of Derivatives Risks and Abuse.

https://www.hsgac.senate.gov/subcommittees/investigations/hearings/chase-whale-trades-a-case-

history-of-derivatives-risks-and-abuses

International Accounting Standards Board. IFRS 9, Financial Instruments, 2014. IFRS Foundation Publications

Department 30 Cannon Street, London EC4M 6XH, United Kingdom

IFRS 13

ASC 815, 320

JPMorgan Chase & Co. Form 10-K of 2013, Page 81.

https://jpmorganchaseco.gcs-web.com/node/107676/html

https://www.bis.org/statistics/d5_1.pdfhttps://www.in.gov/isdh/files/2015_Indiana_University_Health_AFS.pdfhttps://www.sec.gov/Archives/edgar/data/783005/000119312512223521/d335769d10k.htmhttp://www.fasb.org/derivatives/issueg7.shtmlhttp://eprints.maths.ox.ac.uk/1374/https://www.hsgac.senate.gov/subcommittees/investigations/hearings/chase-whale-trades-a-case-history-of-derivatives-risks-and-abuseshttps://www.hsgac.senate.gov/subcommittees/investigations/hearings/chase-whale-trades-a-case-history-of-derivatives-risks-and-abuses

44

Kawaller, Ira (March 2015). “Hypothetically Speaking: Accounting for Commodity Hedges.” AFP Exchange.

pp. 58-61.

https://docs.wixstatic.com/ugd/de837a_c4a7ed959bb749a0811efd061af68cb3.pdf

Kamakura Solutions. Credit Risk, CVA and DVA.” Kamakura Corporation

http://www.kamakuraco.com/Solutions/CreditRiskCVAandDVA.aspx

Pollack, Lisa. (October 18, 2011). “Bank of America results: DOA or DVA? [updated].” Alphaville. Financial

Times.

http://ftalphaville.ft.com/2012/10/29/1235261/overly-processed-accounting-who-eats-this-stuff/

Telecom Italia Prospectus.

http://www.tifinance.lu/_NEWS/Telecom_Italia_Finance_Mandatory_Convertible_Notes-

Ordinary_Share_Pricing_Termsheet_vF.PDF

SAP. Bank Analyzer (FS-BA). Public 2018-6-28, Page 1047

https://help.sap.com/doc/abf8ebe023bc47ecabfd32dd14d62575/9.10/en-US/BankAnalyzer_EN.pdf

Smith, Donald J. (2018) Valuation in a World of CVA, DVA, and FVA: A Tutorial on Debt Securities and

Interest Rate Derivatives. World Scientific Publishing Co.

Sorrentino, M. and Smarra, M. (2015). The Term “Business Model” in Financial Reporting: Does It Need a

Proper Definition? Open Journal of Accounting, 4, 11-22.

http://dx.doi.org/10.4236/ojacct.2015.42002

Strategic Hotels & Resorts, Inc. Form 10-K. December 31, 2014, page 90.

https://www.last10k.com/sec-filings/bee#fullReport

US Securities and Exchange Commission. (August 2007). Form 6-K REPORT OF FOREIGN PRIVATE

ISSUER PURSUANT TO RULE 13a-16 OR 15d-16 UNDER THE SECURITIES EXCHANGE ACT OF 1934,

August 2007, page 57.

http://www.wikinvest.com/stock/Deutsche_Telekom_AG_(DT)/Filing/6-K/2007/F4951044

https://docs.wixstatic.com/ugd/de837a_c4a7ed959bb749a0811efd061af68cb3.pdfhttp://www.kamakuraco.com/Solutions/CreditRiskCVAandDVA.aspxhttp://ftalphaville.ft.com/2011/10/18/705036/bank-of-america-results-doa-or-dva/http://ftalphaville.ft.com/2012/10/29/1235261/overly-processed-accounting-who-eats-this-stuff/http://www.tifinance.lu/_NEWS/Telecom_Italia_Finance_Mandatory_Convertible_Notes-Ordinary_Share_Pricing_Termsheet_vF.PDFhttp://www.tifinance.lu/_NEWS/Telecom_Italia_Finance_Mandatory_Convertible_Notes-Ordinary_Share_Pricing_Termsheet_vF.PDFhttps://help.sap.com/doc/abf8ebe023bc47ecabfd32dd14d62575/9.10/en-US/BankAnalyzer_EN.pdfhttp://dx.doi.org/10.4236/ojacct.2015.42002https://www.last10k.com/sec-filings/bee#fullReporthttp://www.wikinvest.com/stock/Deutsche_Telekom_AG_(DT)/Filing/6-K/2007/F4951044